Fixed vs. adjustable rate mortgages

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The difference between these two rate types is in their names: one doesn't change through the mortgage term, while the other can.

There are two common ways mortgages are structured — and for your purposes, ‘structured’ simply refers to how much you have to pay each month, and over how many months. There are fixed rate mortgages and adjustable rate mortgages (which you’ll often hear referred to by their various aliases like tracker mortgages, variable rate mortgages or just ARMs.)

A fixed rate mortgage is straightforward. A bank quotes you an annual percentage rate and term — say 4 percent for 30 years on a $300,000 loan — and you agree to pay a specific amount every month so that at the end of that 30 years you will have paid off the principal sum you borrowed, the interest you owe to the bank, as well as any associated expenses, all of which will be added up then divided into 360 equal monthly payments.

A variable rate mortgage is a considerably more complicated proposition with many more moving parts and, if you’re not careful, potential financial jump scares. An ARM will generally offer an initial interest rate that is well below fixed rate mortgage rates, however this introductory period will be relatively short — ten years at most, and sometimes as short as a few months. After that introductory period, the ARM’s interest rate will reset and adjust based upon a predetermined algorithm, and keep changing on a predetermined schedule called the adjustment frequency. Adjustments are generally linked to specific benchmarks, like treasury yields — the interest rate that the government agrees to pay on its bonds. Some home buyers might attempt to flip a house before the initial rate expires, though Wealthsimple never suggests buying property with plans to sell it in less than a decade. An ARM might, however, be a very good option for someone who anticipates a significant salary bump in the future, since they’ll be able to enjoy paying lower payments when they’re cash poor.

The significant danger of ARMs is for those lured in by a tantalizing introductory interest rate, only to be shocked to have monthly payments jump significantly — in certain cases even double. Poorly thought out ARMs caused a wave of foreclosures that, you’ll recall, characterized the 2008 financial crisis.

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